One, Two, Many Quasi-Gold-Standard Trilemmas

Michael Bordo of Rutgers University and Harold James of Princeton University…. The parallels between the euro and the gold standard are not exact…. But for the 17 states that now share the single currency, it represents a new gold standard in that their exchange rates with each other are fixed.

That observation is not new, but the authors’ analysis of the tensions that eventually scuppered the gold standard is fresh. Those tensions, they argue, emerged from a trio of “trilemmas”…. One of the three trilemmas is familiar to economists: the “impossible trinity” of fixed rates, free movement of capital and an independent monetary policy…. But Messrs Bordo and James reckon that countries in regimes like the euro and the gold standard may not just be sacrificing their ability to set interest rates; they may also be forsaking financial stability and even undermining democracy.

Start with monetary independence. By throwing away the key of exchange rates, countries must alter their relative domestic prices and wages when they become misaligned…. Unfortunately the euro resembles the flawed interwar version of the gold standard rather than the classical pre-war model. After the gold standard was restored in the 1920s, central banks in surplus states like France (which had rejoined it at an undervalued exchange rate) sterilised the monetary effects of gold inflows so that prices did not rise. That put all the pressure to adjust on countries like Britain, which rejoined the gold standard in 1925 at an overvalued rate. A similarly harsh deflationary process is now under way in peripheral euro-zone countries like Greece. Their adjustment would be much less draconian if the core states were prepared to tolerate considerably higher inflation than the euro-zone average. But Germany fiercely resists this.

The second of the authors’ trilemmas is the incompatibility of fixed exchange rates and capital mobility with financial stability. When countries joined the gold standard, it bestowed a seal of approval that prompted a big influx of foreign money. That pumped up credit, driving an expansion of domestic banks that often ended in grief. Under the gold standard a strong state could support wobbly banks and investors; in pre-war Russia, for example, the central bank was called the “Red Cross of the bourse”. But a weak state could easily forfeit investors’ confidence….

The third trilemma is the most worrying: the potential incompatibility of fixed exchange rates and free movement of capital with democracy…. Although southern Europeans still want to keep the euro, not least because the cost of exit is harsher than that of leaving the gold standard, disenchantment grows. Italian voters said basta to austerity in February; Portugal’s government is fraying in the face of public hostility to tax rises and spending cuts. Northern Europeans are also unhappy. Popular opposition to paying for euro-zone rescues constrains Angela Merkel, the German chancellor, from spelling out the sacrifices voters must make to sustain the euro….

“The European Crisis in the Context of the History of Previous Financial Crises”, NBER Working Paper 19112, June 2013

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Michael Bordo of Rutgers University and Harold James of Princeton University…. The parallels between the euro and the gold standard are not exact…. But for the 17 states that now share the single currency, it represents a new gold standard in that their exchange rates with each other are fixed.